Goals of Monetary Policy and Its conflict among goals
High Employment, Price Stability, Economic Growth, Foreign Exchange Rate Stability, Interest Rate Stability, Financial Market Stability
To reduce unemployment, the Fed increases broad money (M2), by issuing currency, through discount loans, so the monetary base increased and banks can have more reserves to provide loans to customers at lower interest rate, so the result is the investments have been expanded and the unemployment have been reduced (investments needs more employees). However, when M2 increased, the inflations will be happened due to the increased prices of goods and services. Therefore, the high employment goal conflict with the price stability.
Moreover, these two goals conflict through the exchange rate. When M2 increased, the inflation occurred, so the value of dollar will fall. So, by lowering the exchange rate of the dollar, the Fed can stimulate export industries and import competing industries. A lower exchange rate of dollar would increase employment, (industries would produce more, and they will require more employees). But, a higher exchange rate would lower the inflation rate (dollar appreciate).
So, if the Fed wants to lower unemployment, it has an incentive to depress the exchange rate of the dollar below its appropriate level (dollar depreciation). And if it wants to reduce inflation, it has an incentive to raise the exchange rate above the appropriate level. So, the high employment and price stability conflict with the foreign exchange stability.
Through open market purchase, the Fed buys securities from banks so as it increase the banks' reserves. With these reserves, the banks increase their lending, so the interest rate falls. But through open market sale, the Fed sells securities to banks so as it decrease the banks' reserves. With the decreased reserves, the banks cut down their lending, so the interest rates rise. So, through the OMO, the interest rate is affected, and the goal of high employment and price stability conflict with the goal of interest rate stability.
The goals of high employment and of economic growth are not in conflict. High employment fosters economic growth and vice versa. For example, if firms are operating at capacity, as they tend to be in periods of economic growth, they are more willing to invest in new facilities than if they have much excess capacity. In periods of high employment and labor shortages firms try to upgrade the skills of their labor force, and that stimulates economic growth.
Economic growth and price stability have a more complex relationship. The conflict in the short run: policies that are too expansionary, and hence too inflationary, can achieve higher economic growth at first:
- by ensuring that more firms are short of capacity and thus eager to invest
- by temporarily reducing unemployment, and
- by expanding the labor force as firms try to expand their work force by more strenuous recruiting and training of labor.
You may be wondering why Fed notes are considered a liability of the Bank. Banknotes are considered a liability of the bank that issues them because, when notes were invented, they gave their owner a claim on the gold reserves of the issuing bank. Such notes were convertible paper money.
The holders of such a note could convert the note on demand into gold (or some other commodity such as silver) at a guaranteed price. Thus when a bank issued a note, it was holding itself liable to convert that note into a commodity.
Modern banknotes are non convertible. A non convertible note is a banknote that isn't convertible into any commodity and that obtains its value by government fiat or decree- hence the term fiat money. Such banknotes are considered the legal liability of the bank that issues them; however, the bare backed not by commodity reserves but by holdings of securities and loans. The Fed notes are backed by the Fed's holdings of government securities.
1- If the Fed sells 2 million USD of bonds to Irving the Investor, who pays for the bonds with briefcase filled with currency, what happens to reserves and the monetary base? Use T-accounts to explain yours answer.
2- If the Fed sells 2 million USD of bonds to the First National Bank, what happens to reserves and the monetary base? Use T-accounts to explain your answer.
3- Why are open-market operations the most important tool of Fed policy?
4- Why does the Fed try to stabilize interest rate?
